Prepayment Penalties: Efficiency and Predation
41 Pages Posted: 10 Oct 2011 Last revised: 8 Mar 2012
Date Written: March 7, 2011
This paper presents evidence that reductions in mortgage interest rates associated with prepayment penalties are greater for riskier borrowers, as measured by mortgage type, credit scores, and local incomes and education levels. This is consistent with an efficiency view arguing that, by reducing the reclassification risk faced by lenders, prepayment penalties can be welfare-improving. Additional findings indicate that prepayment penalties are also used as a predatory lending tool, but the efficiency view dominates the predatory view in most circumstances. State anti-predatory lending laws restricting the duration and amount of prepayment penalties appear to curb the predatory use of prepayment penalties.
Keywords: prepayment penalties, predatory lending, financial regulation, mortgage crisis, reclassification risk
JEL Classification: G21, G28, G01, D18, L85
Suggested Citation: Suggested Citation